Working Paper: CEPR ID: DP6294
Authors: Rachel Campbell; Kees Koedijk; James R. Lothian; Ronald J. Mahieu
Abstract: We review Irving Fisher?s seminal work on UIP and on the closely related equation linking interest rates and inflation. Like Fisher, we find that the failures of UIP are connected to individual episodes in which errors surrounding exchange rate expectations are persistent, but eventually transitory. We find considerable commonality in deviations from UIP and PPP, suggesting that both of these deviations are driven by a common factor. Using a dynamic latent factor model, we find that deviations from UIP are almost entirely due to forecasting errors in exchange rates, a result consistent with those reported by Fisher a century ago.
Keywords: expectations; formation; Irving Fisher; small-sample problems; UIP
JEL Codes: B01; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate forecast errors (F31) | UIP deviations (L15) |
| episodic monetary shocks (E39) | exchange rate forecast errors (F31) |
| exchange rate forecast errors (F31) | PPP deviations (C59) |
| UIP deviations (L15) | PPP deviations (C59) |